Qualified Research Expenses (QREs) and the Hawaii Tax Credit for Research Activities (HRS §235-110.91): A Comprehensive Compliance and Strategy Guide

Qualified Research Expenses (QREs) are the direct costs incurred by a taxpayer for research activities that meet the specific four-part test defined under federal tax law. In the context of the Hawaii Tax Credit for Research Activities (TCRA), QREs serve as the crucial metric for determining both the foundational federal credit and the subsequent refundable state credit available to certified Qualified High Technology Businesses (QHTBs).

The definition of QREs provides the foundation for claiming the refundable Hawaii TCRA, a vital incentive codified under Hawaii Revised Statutes (HRS) §235-110.91.1 This credit is unique because it offers a refundable benefit, meaning unused portions of the credit can be paid out in cash to the taxpayer, offering crucial liquidity for high-tech ventures.2 However, accessing this benefit requires meticulous adherence to both federal QRE standards (Internal Revenue Code, IRC §41) and strict Hawaii-specific geographic and administrative requirements, which have recently been complicated by legislative changes. The credit program is designed to support economic diversification, focusing primarily on small to medium-sized technology firms committed to local R&D operations.

1. The Foundation of Qualified Research Expenses (QREs)

The concept of QREs is defined federally under IRC §41.3 For any expense to qualify for the Hawaii TCRA, it must first satisfy all federal requirements for the Credit for Increasing Research Activities.1 The term “qualified research expenses” is the sum of two categories of expenditures paid or incurred during the taxable year in carrying on any trade or business: in-house research expenses and contract research expenses.4

1.1 The Federal Four-Part Test for Qualified Research

The underlying research activity to which the QREs relate must meet four stringent federal criteria to be considered “qualified research” 3:

1. Purpose Test (Section 174): Expenditures must be treated as domestic research or experimental expenditures under IRC §174.
2. Technological in Nature: The research must aim to discover information that is technological in nature, often involving physical or biological sciences, engineering, or computer science.
3. Business Component Test: The research must be intended to be useful in the development of a new or improved business component (e.g., a product, process, formula, or technique).
4. Process of Experimentation: Substantially all of the activities must constitute elements of a process of experimentation designed to eliminate uncertainty regarding the development or improvement of the business component.

The integrity of any credit claim often hinges on successfully substantiating the final criterion—the process of experimentation.3 Because the Hawaii credit is derived directly from the federal calculation 1, a deficiency in proving that technological uncertainties were addressed through rigorous experimentation will lead to a full denial of both the federal credit and the resulting refundable state claim. Therefore, businesses must invest heavily in maintaining detailed documentation that outlines the technological uncertainties they faced, the alternatives they evaluated, and the methodologies used to conduct the experimentation, focusing on rigorous compliance with the federal standard.

1.2 Categories of QREs

QREs fall into specific categories, which must be tracked and documented meticulously:

• In-House Research Expenses: These are costs directly related to the performance of qualified research by the taxpayer’s own employees 5:

• Wages for Qualified Services: Salaries paid to employees performing, supervising, or directly supporting qualified research.3 Wages used in figuring the federal work opportunity credit are excluded.6
• Cost of Supplies: Amounts paid or incurred for supplies (tangible property like raw materials and components) used and consumed in the conduct of qualified research.3
• Rental or Lease Costs of Computers: Payments for the right to use computers in the conduct of qualified research.3

• Contract Research Expenses: This includes 65% of amounts paid or incurred to an unrelated third party for qualified research performed on behalf of the taxpayer.2 The remaining 35% is statutorily excluded, as it is presumed to cover non-research overhead, administration, and profit margin.5

2. Defining Hawaii QREs (HI QREs) and Geographic Nexus

The Hawaii TCRA imposes a mandatory geographic restriction: expenses only qualify as HI QREs if they are directly attributable to research activity conducted IN HAWAII.6 This geographic nexus requirement is essential both for achieving QHTB status and for determining the amount of the state credit.

2.1 The Qualified High Technology Business (QHTB) Status

The credit is strictly limited to businesses certified as a QHTB.2 To qualify, a business must meet several criteria 6:

• The business must conduct more than 50% of its activities in qualified research in the State of Hawaii.2 This threshold ensures that the credit primarily supports companies with their core R&D operations based locally.
• The business must be a “small business,” meaning it has no more than 500 employees.8 This restriction focuses the incentive toward mid-market and startup enterprises, intentionally excluding large, multinational corporations.
• The taxpayer must claim a federal tax credit for the same qualified research activities.1

The combination of the high 50% local activity threshold and the employee limit indicates the legislature’s intent to support small to medium-sized, highly research-intensive enterprises that commit their primary R&D focus and employment base to the islands. This structural limitation maximizes the local economic impact per certified dollar.

2.2 Geographic Attribution of HI QREs

The application process requires establishing the precise ratio of Hawaii-based expenses to total federal expenses using Form N-346A. The Department of Taxation (DOTAX) and the Department of Business, Economic Development, and Tourism (DBEDT) require meticulous geographic tracking for the following categories:

• Wages: Only salaries for employees performing, supervising, or directly supporting qualified high-tech research in Hawaii qualify as HI QREs.2
• Supplies: Only materials and prototypes consumed in Hawaii during the R&D process qualify.2
• Contract Research: Only 65% of payments to unaffiliated third parties for qualified services performed in Hawaii qualify.2
• Computer Rentals: The equipment must be used exclusively in Hawaii R&D activities.2

For businesses with multi-state operations, the allocation of QREs faces scrutiny from two angles: first, the IRS verifies the eligibility of the total QREs (federal amount); second, DOTAX reviews the methodology used to attribute expenses to Hawaii. The ability to defend the Hawaii allocation ratio requires robust geographic documentation, such as detailed time-tracking systems, geo-location records, and travel expense logs that substantiate the physical location of qualified services performed.

3. Calculation Mechanics and the Impact of Act 139 (SLH 2024)

The Hawaii TCRA is calculated by taking a proportional share of the federal R&D credit based on the ratio of HI QREs to total Federal QREs.2

$$\text{Hawaii TCRA} = \text{Federal R\&D Credit (Form 6765)} \times \left( \frac{\text{Hawaii QREs}}{\text{Total Federal QREs}} \right)$$

3.1 Reinstatement of the Federal Base Amount

The most substantial change to the TCRA was enacted by Act 139, Session Laws of Hawaii (SLH) 2024, for taxable years beginning after December 31, 2023.2

Previously, HRS §235-110.91 stipulated that the federal base amount in IRC §41 was inapplicable, allowing QHTBs to take credit for all qualified research expenses without regard to previous years’ expenses.1 This structure made the Hawaii credit exceptionally valuable, as it subsidized 20% of the QREs (as referenced in older guidance) rather than just the marginal increase.

Act 139 repealed this provision, meaning the federal base amount calculation is now mandatory for determining the Hawaii credit.2

3.2 Impact on Credit Calculation

Under the new rule, the federal tax credit is calculated only on Excess QREs—the amount by which current year QREs exceed the fixed base amount. The federal base amount is calculated by multiplying the taxpayer’s fixed-base percentage by the average annual gross receipts for the four preceding tax years.2

This change structurally links the Hawaii credit value directly to research growth. For established QHTBs with stable QRE spending that is not accelerating, the base amount will consume a large portion of their current year QREs, resulting in a substantially lower (or zero) federal credit.2 Since the Hawaii credit is a proportional fraction of the federal credit, the state benefit will be correspondingly and drastically reduced compared to prior years.

This mandate transforms the Hawaii TCRA from a universal subsidy on R&D existence into a reward system for increasing research activity. Businesses engaging in R&D must now perform detailed financial modeling to compare the two methods available for calculating the federal credit—the Regular Credit Method (using the fixed-base percentage) and the Alternative Simplified Credit (ASC)—to maximize the initial federal figure, thereby maximizing the total refundable Hawaii benefit.

4. Hawaii State Revenue Office Guidance and Compliance

Claiming the Hawaii TCRA is a uniquely competitive and time-sensitive process governed by two state agencies: DBEDT (Certification) and DOTAX (Claiming).

4.1 The DBEDT Certification Process

The Department of Business, Economic Development, and Tourism (DBEDT) manages the certification of QHTB status and the allocation of the limited pool of credit dollars.2

$5 Million Annual Aggregate Cap

The most challenging administrative hurdle is the $5 million annual aggregate cap on total certified credits.2 Credits are allocated on a first-come, first-served (FCFS) basis.2 Historical data demonstrates the intense competition, noting that in recent years, the cap was reached almost immediately after the application window opened.6

In a recent tax period (2024), 23 QHTBs applied, claiming $3.9 million in tax credits based on $43.3 million in research expenses. Only 18 QHTBs were certified, and 5 QHTBs were disqualified.12 This demonstrates that successful claiming is highly sensitive to administrative speed.

Submission Requirements and Deadlines

The QHTB must submit the following to DBEDT:

1. Completed, Signed N-346A Form: This form, titled “Certified Statement of Research and Development Costs,” is mandatory and must be the most updated version (older forms are not accepted).6
2. Application Timing: The deadline for submission to DBEDT is March 31 following the taxable year in which the research was conducted.1 The date and time the completed N-346A is received by DBEDT determines the priority queue for the FCFS allocation.6

Due to the intense competition for the $5 million cap, QHTBs cannot afford to wait for the standard tax deadline. They must finalize their QRE quantification and federal credit calculation by late February to ensure their N-346A submission is among the first received in March.

4.2 DOTAX Claim Filing Requirements

Once DBEDT certifies the QREs and the credit amount, they mail Part II of the certified N-346A back to the taxpayer.6 The taxpayer then files the claim with the Department of Taxation (DOTAX) using Form N-346 (Tax Credit for Research Activities).6

• Required Attachments: The taxpayer must attach the certified Part II of Form N-346A and a copy of the federal Form 6765 (Credit for Increasing Research Activities) to Form N-346.6
• Flow-Through Entities: If the QHTB is a partnership or S corporation, the business must also attach a copy of Schedule K-1 establishing the owner’s allocated share of the credit.6
• Ongoing Compliance: QHTBs are also required to submit an annual survey by June 30 for ongoing program monitoring and compliance.2

5. Practical Application and Illustrative Example

The following example demonstrates the calculation of the Hawaii TCRA for a Hypothetical QHTB, Kilauea Software Labs (KSL), for the 2024 tax year, highlighting the material impact of the reinstated federal base amount.

KSL is a certified QHTB developing proprietary cloud software exclusively in its Maui facility. KSL uses the Regular Credit calculation method.

Analysis of the Example:

Had the previous rule been in effect, KSL would have received a refundable credit of approximately $190,000 (assuming a 20% rate applied to all $950,000 of HI QREs, as suggested by older formulas 7). However, with the reinstatement of the base amount, KSL’s credit is reduced to $19,000. This disparity highlights the critical change: $90\%$ of KSL’s current R&D spending was offset by the historical base amount before any state proration occurred. The resulting reduction in the calculated credit underscores that the Hawaii TCRA is now highly leveraged against the QHTB’s ability to demonstrate significant year-over-year QRE growth that exceeds the calculated federal base.

6. Strategic Compliance and Policy Dynamics

6.1 Key Administrative Requirements Summary

To successfully secure the refundable credit, QHTBs must manage the compliance timeline with military precision, focusing on the FCFS cap competition.

6.2 Economic Impact and Policy Efficiency

While the TCRA promotes innovation in sectors like biotechnology, software, and ocean sciences 2, its economic impact is constrained by the administrative structure. Policy analysis indicates that the program operates at a very small scale, which limits its potential for substantial economic growth.14

The high marginal social return to R&D spending (estimated at 58 percent, significantly higher than the private return of 14 percent) justifies the tax incentive.14 However, the state’s decision to maintain a low annual cap of $5 million combined with the FCFS rationing rule creates administrative friction that discourages technology firms from applying.15 This rationing mechanism determines credit access based on administrative speed rather than the quality or scale of the research itself, failing to maximize the intended R&D spillover effects across the state’s economy. The total tax credit claimed in 2024 was $3.9 million, yet only $2.6 million was actually certified, demonstrating the persistent gap between demand and certification capacity.12

6.3 Compliance Recommendations

For QHTBs seeking to maximize the refundable Hawaii TCRA benefit, several strategic adjustments are necessary to address the high administrative and technical hurdles:

1. Accelerated Quantification: The calculation of federal QREs and the corresponding federal credit must be completed immediately at the start of the new calendar year. The strict March 31 DBEDT deadline, and the realistic FCFS constraint, demands that the R&D quantification for Hawaii take precedence over routine tax filing preparations.
2. Robust Location Documentation: QHTBs with any out-of-state activity must establish granular internal controls for geographic tracking. This includes mandating time-tracking systems that link labor hours not only to the qualified research project but also to the physical location of performance, rigorously defending the Hawaii Allocation Ratio under DOTAX audit.
3. Financial Modeling of Growth: Because the credit is now dependent on exceeding the federal base amount, QHTBs must perform sensitivity analysis comparing the federal Regular Method against the Alternative Simplified Credit to identify the method that generates the greatest amount of federal Excess QREs, thereby securing the largest possible Hawaii refundable credit.

Conclusion

The Hawaii Tax Credit for Research Activities (HRS §235-110.91) offers QHTBs a substantial, refundable income tax credit, serving as a critical financial incentive for localized technological innovation. The core metric, Qualified Research Expenses (QREs), must meet the stringent federal definition under IRC §41 and demonstrate a clear geographic nexus, meaning the activity must be physically conducted in Hawaii.

The significant modification introduced by Act 139 (SLH 2024), which reinstated the federal base amount calculation, fundamentally shifts the program’s utility. The credit is no longer a simple subsidy for the existence of R&D but rather a powerful incentive tied directly to the growth of research activity. Consequently, compliance now requires advanced technical expertise in calculating the federal base amount and meticulous administrative precision to secure certification from DBEDT before the $5 million annual cap is exhausted. Successfully navigating the highly competitive, FCFS allocation process and rigorously defending the Hawaii QRE ratio are non-negotiable prerequisites for realizing the financial benefit of this crucial state tax credit.

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